Tell apart the different origins of liquidity risk and set out the particular difficulties that various kinds of financial institution meet when managing it.
The idea
Liquidity risk has two basic origins that feed each other. Market (transaction) liquidity risk is the risk that a position cannot be sold or hedged quickly without paying a wide bid-ask spread or moving the price. It sits on the asset side. Funding liquidity risk is the risk that a firm cannot meet cash or collateral obligations as they fall due, or cannot roll over its borrowing. It sits on the liability side. Institutions differ in where the strain comes from. Banks face deposit withdrawals, wholesale rollover and drawdowns of committed credit lines. Insurers face surrenders and large claims. Pension funds and other derivative users face variation margin calls. Hedge funds face higher prime broker margins and investor redemptions, and open-end funds face redemptions against illiquid holdings. A solvent firm can still be illiquid. For the exam, identify the origin first, then the channel specific to the institution.
A practice question
Which statement correctly distinguishes funding liquidity risk from market (transaction) liquidity risk?
- Funding liquidity risk is the risk of failing to meet payment or collateral obligations or to roll debt; market liquidity risk is the risk that a position cannot be traded quickly at fair prices. - correct
- Funding liquidity risk is the risk that a position cannot be traded without an adverse price impact, while market liquidity risk is the risk of being unable to meet payment or collateral obligations as they fall due or to roll over borrowing.Why not: Swaps the two definitions: the trading-cost risk is market liquidity, the payment risk is funding liquidity.
- Funding liquidity risk is the loss from falling prices of assets held, while market liquidity risk is the loss when a counterparty fails to pay.Why not: Confuses liquidity risks with market risk and credit risk, which are separate risk types.
- Both are forms of insolvency risk, so a firm with assets greater than liabilities cannot suffer either of them.Why not: Treats liquidity as solvency; a solvent firm can still be unable to pay on time or to sell assets at fair prices.
Funding liquidity concerns the liability side (meeting obligations, rolling debt); market liquidity concerns the asset side (cost and speed of trading). Neither is the same as solvency or as price risk.
A harder one
An open-end bond fund offers daily redemptions at net asset value (NAV) but holds mostly thinly traded corporate bonds. Which feature creates an incentive for investors to redeem early in stress?
- Redemptions are met equally by all investors regardless of when they leave, so early redemption brings no advantageWhy not: States the opposite of the first-mover advantage: the liquidation cost is borne by remaining investors, not shared equally.
- The fund is unleveraged, and an unleveraged fund by definition has no liquidity mismatchWhy not: Confuses leverage with liquidity mismatch; the mismatch comes from daily redemption against illiquid assets.
- The fund can only face redemptions if the credit ratings of its bonds fall below investment gradeWhy not: Makes credit deterioration a necessary trigger; redemptions can occur whenever investors expect that others will leave.
- Redeemers receive NAV before illiquid bonds are sold, so the selling cost falls on those who remain - correct
The liquidity mismatch between daily liabilities and illiquid assets, combined with NAV pricing that does not reflect the cost of selling, rewards investors who redeem first and so can start a run.
The hardest tier
A securities dealer finances an inventory of ten-year corporate bonds with overnight repo. Which statement most accurately describes its liquidity risk?
- Rollover risk: if lenders refuse to roll or raise haircuts, forced sales into a stressed market link funding and market liquidity risk. - correct
- Because repo is secured, liquidity risk is eliminated and only the credit risk of the collateral remains, with no refinancing exposure at all.Why not: Treats secured as risk-free; secured funding can still be withdrawn or repriced through higher haircuts at rollover.
- Overnight tenor lowers liquidity risk because the dealer reprices each day and so is never exposed to a funding shortfall.Why not: Confuses cheap short-term funding with safe funding; daily rollover concentrates refinancing risk.
- The risk is purely market liquidity, because funding terms are unaffected by the condition of the collateral.Why not: Ignores that haircuts and willingness to lend depend on collateral quality, linking funding and market liquidity.
Long-dated, less liquid assets funded overnight create a maturity mismatch; a failure to roll forces asset sales, and distressed sales depress prices and make the next rollover harder.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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